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Supply, Demand, and Government Policies
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Supply, Demand, and Government Policies
• In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.
• While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.
• One of the roles of economists is to use their theories to assist in the development of policies.
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CONTROLS ON PRICES
• Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and floors.
• Price Ceiling • A legal maximum on the price at which a good can
be sold.
• Price Floor• A legal minimum on the price at which a good can
be sold.
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How Price Ceilings Affect Market Outcomes
• Two outcomes are possible when the government imposes a price ceiling:• The price ceiling is not binding if set above the
equilibrium price. • The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Quantity ofGasoline
0
Price ofGasoline
Equilibriumquantity
$4 Priceceiling
Equilibriumprice
Demand
Supply
3
100
Figure 1 A Market with a Price Ceiling
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(b) A Price Ceiling That Is Binding
Quantity ofGasoline
0
Price ofGasoline
Demand
Supply
2 PriceceilingShortage
75
Quantitysupplied
125
Quantitydemanded
Equilibriumprice
$3
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How Price Ceilings Affect Market Outcomes
• Effects of Price Ceilings
• A binding price ceiling creates• shortages because QD > QS.
• Example: Gasoline shortage of the 1970s
• nonprice rationing• Examples: Long lines, discrimination by sellers
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• In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.
• What was responsible for the long gas lines?
CASE STUDY: Lines at the Gas Pump
• Economists blame government regulations that limited the price, oil companies could charge for gasoline.
Figure 2 The Market for Gasoline with a Price Ceiling
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(a) The Price Ceiling on Gasoline Is Not Binding
Quantity ofGasoline
0
Price ofGasoline
1. Initially,the priceceilingis notbinding . . . Price ceiling
Demand
Supply, S1
P1
Q1
Figure 2 The Market for Gasoline with a Price Ceiling
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(b) The Price Ceiling on Gasoline Is Binding
Quantity ofGasoline
0
Price ofGasoline
Demand
S1
S2
Price ceiling
QS
4. . . . resultingin ashortage.
3. . . . the priceceiling becomesbinding . . .
2. . . . but whensupply falls . . .
P2
QD
P1
Q1
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CASE STUDY: Rent Control in the Short Run and Long Run
• Rent controls are ceilings placed on the rents that landlords may charge their tenants.
• The goal of rent control policy is to help the poor by making housing more affordable.
• One economist called rent control “the best way to destroy a city, other than bombing.”
Figure 3 Rent Control in the Short Run and in the Long Run
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(a) Rent Control in the Short Run(supply and demand are inelastic)
Quantity ofApartments
0
Supply
Controlled rent
RentalPrice of
Apartment
Demand
Shortage
Figure 3 Rent Control in the Short Run and in the Long Run
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(b) Rent Control in the Long Run(supply and demand are elastic)
0
RentalPrice of
Apartment
Quantity ofApartments
Demand
Supply
Controlled rent
Shortage
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How Price Floors Affect Market Outcomes
• When the government imposes a price floor, two outcomes are possible.
• The price floor is not binding if set below the equilibrium price.
• The price floor is binding if set above the equilibrium price, leading to a surplus.
Figure 4 A Market with a Price Floor
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(a) A Price Floor That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
2
Pricefloor
Equilibriumprice
Demand
Supply
$3
100
Figure 4 A Market with a Price Floor
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(b) A Price Floor That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
$4Pricefloor
80
Quantitydemanded
120
Quantitysupplied
Equilibriumprice
Surplus
3
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The Minimum Wage
• An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
Figure 5 How the Minimum Wage Affects the Labor Market
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Quantity ofLabor
Wage
0
Labordemand
LaborSupply
Equilibriumemployment
Equilibriumwage
Figure 5 How the Minimum Wage Affects the Labor Market
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Quantity ofLabor
Wage
0
LaborSupplyLabor surplus
(unemployment)
Labordemand
Minimumwage
Quantitydemanded
Quantitysupplied
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Other Measures of Interventions
Evaluate price controls Other Measures:• Subsidies: rent or wage
• Don’t reduce quantity and quality• But need taxes to finance the subsidies• Taxation issues
• Rationing: Quota, license, permit• Often used in centrally planned economies
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The Market forThe Market for Taxi Rides in the Taxi Rides in the
Absence of Government ControlsAbsence of Government Controls
Without government intervention, the market reaches equilibrium with 10 million rides taken per year at a fare of $5 per ride.
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Excise taxes are taxes on the purchase or sale of a good.They have effects similar to quotas:
raise the price paid by buyers and reduce the price received by sellers,
and drive a wedge between the two.
Examples: Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides
Excise Taxes
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Effect of an Excise Tax Levied on the Sales of Taxi Rides
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Effect of anEffect of an Excise Tax Levied on Excise Tax Levied on the Purchases of Taxi Ridesthe Purchases of Taxi Rides
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The incidence of a tax is a measure of who really pays it.Who really bears the tax burden (higher prices to consumers and lower prices to sellers) does not depend on who officially pays the tax. Depending on the shapes of supply and demand curves, the incidence of an excise tax may be divided differently.
The wedge between the demand price and supply price becomes the government’s tax revenue.
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The Revenue from an Excise Tax
Area of the shaded rectangle: $2 per ride × 8 million rides = $16 million.
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Excise taxes also cause inefficiency: excess burden or deadweight loss.
This excess burden, or deadweight loss, meansthat the true cost is always larger than the amount paid in taxes.
Excise taxes prevent some mutually beneficial transactions.
They also encourage illegal activity in attempts to avoid the tax.